HP Down, But Not Out

By: Paul McWilliams

This grand old tech stock has seen better days, and its recent acquisition imbroglio spotlights some of the company's recent transition challenges, but there's at least a bounce worth playing here, notes Paul McWilliams of Next Inning Technology Research.

I have received quite a few e-mails from readers today expressing appreciation for my call to avoid Hewlett-Packard (HPQ) ahead of its quarterly report. However, with the cat now out of the bag, it's now time to reevaluate the company.

HPQ announced it took an $8.8 billion writeoff associated with its purchase of UK-based Autonomy. Evidently, HPQ has discovered some very serious fraud and misrepresentations associated with the Autonomy purchase, and is now pushing for a criminal investigation in both the US and UK. HPQ will also file a civil suit in an attempt to collect damages.

HPQ announced its intent to purchase Autonomy during the summer of 2011 for $10 billion in cash, which as I noted then, equated to a price-to-sales ratio over 11. Following this news, I wrote that the price was not only far too high, but also that the acquisition strays from HPQ's core competency, and what I viewed as the appropriate business model for HPQ to leverage going forward.

However, given the many other bad decisions then current HPQ CEO Leo Apotheker was making, the decision to buy Autonomy wasn't surprising. To say I was critical of Apotheker during his short tenure as CEO was be a gross understatement.

When Meg Whitman was hired to take over as CEO, my first suggestion was that she cancel the pending acquisition of Autonomy and pay what would have been a modest penalty. That didn't happen, and now we've learned that Autonomy was cooking its books so bad that HPQ was forced to write down the value of the goodwill and intangible assets that came with Autonomy by roughly $8.8 billion.

As I see it, this is just one more piece of evidence the HPQ board of directors is dysfunctional—how could a competent board of directors approve an acquisition that was this grossly overvalued, and why didn't HPQ's accounting team find what had to be obvious misrepresentations?

Setting aside the miserable management decisions that have led HPQ to its current position and destroyed roughly 75% of the value of HPQ's stock, it appears Whitman is making good decisions and playing the hand she was dealt about as well she possibly could.

Make no mistake, HPQ is still a lump of coal, and no matter how much force Whitman exerts, it may never be enough to turn it into a diamond. However, given the notable operational improvements HPQ showed in its fiscal fourth quarter—evidenced by both a boost in HPQ's non-GAAP operating margin (up both year-over-year and sequentially) and surprisingly strong free cash flow—I think there is now room to speculate in a 10% bounce from the current price of $11.80. Or, at the very least, a fill of the opening gap, which implies about a 7% rise from $11.80.

Investors with a strong stomach might even bet that Whitman turns this situation around. In other words, I now think there is room to speculate.